Fructivore Investments

I should make it clear at the outset of this article that I’m not an economist. But, like many people who begin their speeches with those words, I won’t let it affect what I have to say.

I have made it clear in the past that I take a sanguine view of the possibility of inflation, since the massive deflation across all asset classes (stocks, real estate, many debt instruments and some commodities), amounting to tens of trillions of dollars, in my view massively outweighs even the cutting of interest rates to nothing and the large deficits anticipated over the next ten years. However, there is an equally convincing reason to think that hyperinflation will not be a problem: Because everyone thinks it will.

As I mentioned in my article about the New York Times indicator, whenever a particular stock market or macroeconomic view is popular enough that a book about it makes the best seller list, it’s time to get out. And what did I see in an article in Fortune.com early last week? An article about how hyperinflation won’t die, and the words  “Adam Fergusson’s When Money Dies: the Nightmare of the Weimar Collapse was recently offered at $1,705.63. A rushed paperback UK edition of Fergusson’s book has held onto the number one spot for business books on Amazon UK for more than twenty-six days and is now climbing Amazon’s US rankings.” I think that’s a good enough hit for the New York Times indicator.

Just ask Hugh Hendry, a macroeconomic hedge fund manager with a dreamy accent and an enormous brain. He reports that he has never seen such a crowded trade as the absolute certainty of hyperinflation. In my view, the fact that a trade is so crowded is reason enough to consider not just declining to jump aboard the bandwagon, but actually taking the other side of it. And there is nothing so dangerous as absolute certainty. Hendry himself is actually willing to hold the long term government bonds.

Of course, in that same interview, Hendry said that quantitative easing has a mixed record in history and he is definitely afraid of deflation, since despite the willingness of the US government to ease and to engage in deficit spending, the private sector is still not playing ball. The trouble is that in a normal environment, it pays to take risks that no one else is willing to take, but in a deflationary environment this is often not the case. It doesn’t pay to stick your neck out by investing and expanding capital and payrolls; it pays to go into turtle mode and stock up on government bonds and cash. Now, I have seen a recent uptick of articles about deflation, but no books. Furthermore, I can see the case for deflation a lot better than for hyperinflation.

As hyperinflation is contraindicated by the New York Times indicator and the numbers involved, it is pretty clear that deflation is the real risk we’re facing, and it is a pretty severe risk for any economy but especially a highly leveraged one like ours (did I mention that I like companies that are paying their debts down while they can?). As I said, I have seen a spate of deflation articles recently, but nothing I would call a crowded trade, apart from the continued bull market in US government bonds despite the unusually low interest rates. But deflation certainly worries me more than the remote possibility of excessive inflation. So maybe “cheer up” isn’t really the right sentiment.

I hope that the hyperinflation fearmongers and the gold people (who are also selling books and articles and gold coins over the radio) realize that the steps we have taken so far are not enough to create hyperinflation or possibly not even enough to prevent deflation, and that the stimulus and easing we have had so far was in fact not a bad idea, but instead just too small of an idea. Ireland embraced austerity early; it was one of the first countries in Europe to do so, and it remains mired in the same recessionary spiral as Greece is and the rest of Europe may not be able to avoid. China embraced a massive stimulus and is growing right now, assuming that China’s reported figures are credible. Commentators have said that we need to get the fiscal house in order before we get hit by the next cyclical recession and consequent erosion in the tax base, but I say that we actually can’t even begin the next cycle until we’re done with this one, and right now it doesn’t look like we’re even close.

Let me paint you a worst-case scenario (well, not the worst-case, but a pretty bad case, anyway). The US is right now treading a middle ground, with no deficit cutting but no further large-scale stimulus packages in the works (extending unemployment benefits props up demand, but can’t really create it). I hope it doesn’t require Europe to blow up from austerity before the US decides that avoiding deflation is worth what it costs. But if it does, we can always print a ton of money and buy the remnants of Europe’s capital assets with it.

I’m sure that’s what China would do.

Benjamin Graham gave two useful pieces of advice that are applicable during earnings season. First, don’t pay too much attention to the results of a single quarter. Second, when paying too much attention to the results of a single quarter, make sure that you strip out the nonrecurring events in order to get a better picture of actual earnings power.

So, last week two stocks I’ve recommended here have reported quarterly earnings (as have several others, but I’m focusing on these two). The first is Chiquita Brands (CQB), and the second is Linn Energy (LINE).

Chiquita Brands reported earnings of $1.40 a share apart from a nonrecurring profit, the sale of some of its interest in a fruit drink concern to Danone. This caused the share price to rise to over $14 a share, producing a 10x multiple of this quarter’s earnings alone. Of course, this is typically Chiquita’s biggest quarter, so I don’t think that too much should be made of this.

However, this is still notable because Chiquita Brands also moderated its full year earnings forecast to $80-90 million in comparable earnings, down from the $100-120 million they claimed last quarter. Normally such an event would dampen market enthusiasm, but considering the European debt crisis reached the critical phase during last quarter, and the Euro dropped briefly to below 1.20, this came as no surprise. Furthermore, this forecast is based on the the assumption that the euro will stay at around 1.26. It is in fact 1.30 as of this writing, and may increase further now that the Europeans are fetishizing austerity.

Now, as I mentioned before, I have very sanguine views of inflation and so I don’t think it is vitally important to close the deficit gap very soon, particularly with such an anemic looking recovery. This applies doubly so in Europe, where the social safety net is much larger and so austerity actually has some meaning. So, this un-Keynesian move by Europe will possibly slow or even shrink the European economy, make their exports more expensive, and possibly result in the occasional riot. But, it is more likely than not that it will cause the Euro to go up against the dollar, which is good for Chiquita Brands.

Of course, Chiquita is now reaping the benefits of the change to a formerly unequal tariff regime, which based on current volumes will save them $30 million a year, rising to $60 million when the next phase of the tariff adjustments occur by 2017 or 2019. Being able to compete with banana growers from regions not subject to the tariff might even allow them to increase their volume in future, particularly in the face of overall banana price declines. Of course, the wise value investor does not indulge in rosy projections of the future, but based on their current showing alone Chiquita is still nicely positioned. If earnings for the year are $80 million their current P/E is 8.25, and at $90 million, 7.33.

Chiquita also managed to pay down another $20 million in debt this quarter, and depreciation and amortization has run to $29 million year to date, with capital expenditures at only $16 million year to date, so that appears to be an extra $26m in annualized free cash flow. But I should note that historically capital expenditures have run higher than depreciation.

During their earnings call, Chiquita also mentioned that they wanted to buy back another $40-$50 million in debt before they would feel comfortable with share buybacks or other ways to return cash to investors. Of course, that’s several quarters of free cash flow away, and a lot can happen in several quarters, so I wouldn’t put too much stock in it. But the better their interest coverage becomes, the more likely it is that they can refinance their high-interest borrowings, which would also produce a substantial benefit to shareholders.

On the whole, then, I am very pleased with Chiquita’s performance and despite the advance in share price, I think Chiquita is still underpriced.

Linn Energy (LINE), the other company I wanted to discuss, has a more opaque set of figures, and this may be due to the fact that their derivatives strategy is more integral to their business. But on the other hand, Warren Buffett has stated that if a company wants you to understand its financial statements, you will understand them, and if a company doesn’t want you to understand its financial statements, you won’t understand them. I will warn you, the following post is full of accounting.

Chief among my complaints is the fact that their latest 10-Q doesn’t include a three month cash flow statement, requiring you to open last quarter’s 10-Q and subtract. At any rate, their net income is flat at $60 million for the quarter, well under their latest distribution of roughly $80 million, but of course it is cash flow that drives the yield.

They are kind enough to separate their “core” operations from their derivatives trades, and net income plus depreciation and amortization for the three months did in fact come to about $120 million. From their derivatives activities, they reported $90 million in derivatives profits for the quarter, but only $80 million of that was cash received. As I’ve stated before, they hedge their production several years in advance, so a small movement in oil and gas prices can produce a significant divergence in derivatives income. Actually, the price of oil has certainly been more stable than in 2008 and 2009, but since the prices that Linn Energy locked in for oil is well above the current market price, the large amount of cash from their derivatives is somewhat anomalous, although derivatives income plus sales should not be.

On the next line, they reported a loss of nearly $75 million on cancelled derivatives, which after a little digging in the report I discovered to be $1.2 billion in pay-fixed, receive-floating interest rate swaps. I found this entry curious; the only exposure that Linn Energy had to rising interest rates was on its line of credit, which had an outstanding balance of $900 million at the end of the first quarter and $600 million at the end of the second. Linn Energy had restructured its debt recently to pay for a large acquisition, so clearing out the swaps makes sense, and at any rate I believe that these swaps at the very least are a nonrecurring event.

The final line on the derivatives section of the cash flow statement is premiums paid for derivatives. As I said, Linn Energy engages in careful hedging of the prices of oil and natural gas many years into the future as part of its core strategy, so spending large amounts on derivatives–a total of $91 million year to date–is somewhat to be expected. But Linn Energy spent approximately $90 million on derivatives for the whole of 2009, so although this category may be recurring, the total amount spent by only the second quarter may be anomalously high.

So, where does that leave us in assessing Linn Energy’s sustainable cash flow? First of all, those losses on interest rate swaps are a nonrecurring event, but I also take the position that they are not really an operations expense. As near as I can tell, they were entered into to hedge interest rate exposure on their line of credit, and therefore, they should properly be imputed to the financing cash flows section. As for the derivatives, we might say that since they spent $90 million for all of last year (although previous years involved larger amounts), that the company may have just decided to purchase a year’s worth of derivatives all at once, and if we spread them over a year we find that only $22.5 million should be imputed to this quarter. Taking that into account, we have operating cash flows of $90 million for the quarter, just about enough to cover their distribution. Of course, since the purpose of a company in Linn’s space is to distribute all the cash it can spare, this is not of great concern in terms of coverage.

In fact, we might even be persuaded to take a more generous view of that $90 million in derivatives purchases, since on the next sections of the balance sheet we find that Linn Energy made nearly $600 million in acquisitions for the quarter and nearly $800 million year to date. Obviously, these acquisitions have future production that has to be hedged, so it is likely that some of these hedges are for the future production of the acquisitions, and so there is an argument for classifying the purchases of such derivatives as a use of investing cash flow, thus improving the operating cash flow even further. However, these hedges are part of Linn’s operational strategy, and are intended to reduce their exposure to the price of oil and natural gas rather than speculate on it, and at any rate the amount of the adjustment is difficult to determine, so I think the correct and conservative approach is to leave the derivatives purchase under the operations category and just to make a mental note that things might be better than they appear.

(If I sound unusually pedantic about the source and allocation of cash flow, it’s because I’ve been reading a book called, funnily enough, Creative Cash Flow Reporting, by Mulford and Comiskey. The title is somewhat misleading, as the authors are very much opposed to creative reporting. But so far it’s a good book and I recommend it).

Turning again to the acquisitions, a typical cash flow watcher would be somewhat concerned that depreciation and amortization year to date have come to less than $125 million, while acquisitions have come to nearly $775 million. Surely, they say, this is a sign of vastly negative free cash flow. Normally they would be correct, but Linn Energy financed these new acquisitions by issuing equity and debt securities rather than reinvested earnings (which is just as well because their policy leaves them no retained earnings to reinvest).

I’m not quite sure how to interpret the debt financing of acquisitions. Based on the $90 million in cash flow from operations I calculated above, their interest is covered three times, which appears safe enough, but there is a wrinkle involved with borrowing against oil fields and other finite assets. When an asset is subject to depletion, it is customary to set aside additional income from the asset in order to pay down principal, because borrowing $700 million on an oil field, extracting ten years’ worth of oil from it, and then expecting to roll over the full $700 million when it falls due, is nothing short of ridiculous. This is why most lenders against such assets require a “sinking fund” provision that requires the borrower to pay down portions of the principal over the life of the loan (generally there is no actual “fund” involved; the company just buys back the bonds according to the agreed-upon schedule, so “fund” is a verb and “sinking” is an adverb). It is curious that Linn Energy’s lenders for this current acquisition did not insist on such a fund. True, they have all of Linn Energy’s assets to sue for, not just the current field, but all of Linn Energy’s properties have the same finite character. Here, Linn Energy will have to decide for itself what amount to set aside for principal, and this amount will definitely have to be higher than nothing.

Now, finding all of this out took a bit of digging through the quarterly report and a number of supplemental 8-K reports, but I think it was worth it to conclude that on a conservative basis, Linn Energy is earnings its distribution and not too much else. Recalling the Warren Buffet quote above, Linn Energy promoted in its announcement of quarterly results, its “adjusted EBITDA,” which is of course, non-GAAP. I’ll never understand why equity investors care about EBITDA, since all of I and all of T are taken out before they see anything, and whatever amount of D and A has to be replaced gets to be replaced by them as well. Even bond investors, for whom EBITDA was originally invented, have to worry about D and A. At any rate, adjusted EBITDA, not surprisingly, was nearly twice my estimate of $90 million in sustainable cash flow for the quarter.

So, where does that leave us from an investing decision standpoint? Linn Energy is earning its distribution, which at 8.4% is both attractive looking and tax-deferred (as with other pass-through tax entities, distributions are not taxed but lower the holder’s basis), and Linn Energy’s hedging strategy mitigates the risk from energy prices. And they are seeing excellent results from their new acquisitions. On the other hand, their current hedges are at a higher-than-market price, and in the next couple of years they step down. Of course, any new acquisitions made by Linn Energy will also be based on the market price, but as it stands I don’t know that I see the possibility of any major improvements in Linn’s position and wouldn’t care to speculate on it, so my basic view is that for Linn’s distribution, what you see is what you get. And if the price goes up much further, what you get isn’t that huge, so I would sell if it goes up much further.

For once I can mention a company that most of you may have heard of. Seagate Technology (STX) is the world’s largest hard drive maker, producing a wide range of standard hard drives and since December of 2009 has also been producing a line of solid state drives, although they were a late entrant to the market. Of course, for enterprise or most consumer electronics, the spinny magnetic disk isn’t going anywhere anytime soon.

But what makes Seagate pop up on everyone’s radar these days is, of course, their P/E ratio of 4 and a quarter, which is almost inconceivable in a company this large (market cap of $6 billion and annual sales of about $12 billion) and this well followed. My  initial instinct is that their earnings were distorted by nonrecurring gains, but I found that not to be the case. But I did find that the company had substantial tax benefits accrued and therefore has paid a negligible amount for income taxes year to date, but that only pushes the P/E up to about 7. I can’t explain why such a large company should be the subject of this degree of market neglect (and large competitor Western Digital is also trading a low P/E), but I couldn’t explain the mania for subprime mortgage derivatives either, and the wise value investor just takes cheapness as he or she finds it.

I didn’t find any major nonrecurring events in fiscal year 2010 (Seagate’s fiscal year ends in June), but of course in fiscal year 2009 , like nearly every company with significant goodwill on the books, they wrote theirs off in its entirety. I’ve stated previously that goodwill writeoffs are a noncash expense, and of course goodwill on the balance sheet is a phantom asset, so it can safely be ignored in the majority of situations. Even ignoring the goodwill writeoff, they reported a loss in fiscal year 2009 as sales declined by 23%, but sales for this year seem to have rebounded at least to 2007 levels.

In terms of earnings and cash flows, the company’s free cash flow has been roughly equivalent to earnings, as depreciation and capital expenditures have tracked each other pretty well over the last few years. It was even nearly positive in fiscal year 2009 owing to a decline in capital expenditures ($600 million as opposed to $900 million), and the low level of capital expenditures seems to be continuing for the first three quarters of 2010 (less than $400 million year to date). Earnings year to date have been $1.2 billion, and depreciation $600 million, so the year’s free cash flow to date is $1.4 billion, which is nearly $1.9 billion on an annual basis, creating a current price/free cash flow from operations ratio of less than 3.5. Even if capital expenditures return to historical levels, free cash flow would come to $1.4 or $1.5 billion. This produces, again a price/free cash flow from operations of around 4.5, a definitely attractive situation.

Of course, price/free cash flow from operations is calculated before interest and taxes, and taking those into account we have a projected long term price/free cash flow ratio of approximately 7, which is still notably low for a company of this size, market presence, and stability.

Turning to the balance sheet, most notable is the very top entry: over $2 billion in cash, and $200 million more in short term investments. This is almost 1/3 of the market cap. Midway through fiscal year 2009, Seagate suspended its modest dividend, and despite its impressive cash flow, it has also ceased to engage in shareholder buybacks, which totaled $1.3 billion in fiscal years 2008 and 2007. It may be unseemly to want a cash return on investment from a high technology firm, but I think nowadays hard drives are commoditized enough to be able to support dividend payments, and the rate of cash accumulation on the balance sheet is fairly good evidence for my view.

Seagate claims that they suspended the dividend for liquidity reasons, and on paper their liabilities do come to 65% of their assets, but their interest coverage ratio for 2010 to date is approximately 10x based on earnings alone, suggesting to me that they have more than adequate liquidity. Curiously, their credit rating is a mere BB+, the best of the sub-investment grade ratings, and since a coverage ratio of 10x is more consistent with an AA rating, I think it is the apparent low level of asset coverage that gives the ratings agencies concern.

However, the apparent low level of asset coverage and high debt should be analyzed in view of Damodaran’s suggestion of a “research asset.” Research and development produce benefits that are considered by accountants to be too nebulous to capitalize (or lend money against), so they must be expensed. However, R & D produces a definite benefit to the company, and in the hard drive business it is a practical necessity. Seagate has spent approximately $900 million on R & D every year for the last three full fiscal years, and is on track to do so in fiscal year 2010 as well. As R & D has been a large and growing category of “expense” for Seagate I can’t say that amortization of this theoretical research asset is faster than its accrual, so it would definitely not be a source of free cash flow. But it should occupy a significant space on the balance sheet; it would certainly explain why a company with $1.5 billion in shareholder’s equity can produce projected earnings of roughly $1 billion a year.

I will add that I don’t like their “anti-dilution” policy of buying back shares to offset the effect of stock grants and options exercises; it assures that they buy back stock after it goes up, not before.

On the whole, though, I expect that Seagate’s strong operations backed up by a demonstrated willingness to invest in capital and product development, should allow it to retain its market positions and generate the projected cash flows that indicate it to be a very attractively priced opportunity.

I have had occasion to suggest Capstead Mortgage as an attractive purchase partially based on attractive economics created by historically low interest rates, and partially based on the number of difficulties in evaluating most other investment firms that are not encountered with this one. Capstead Mortgage purchases adjustable rate mortgages on a leveraged basis and holds them in order to profit on the interest differential between the mortgages and their own cost of funds. The fact that all their mortgages are adjustable rate insulates them from most interest rate volatility, and the fact that the mortgages are all GNMA, Fannie, or Freddie securities insulates them from the possibility of default, as the government is explicitly guaranteeing them for the foreseeable future–taxpayers are understandably irate that their tax money is going to bail out these institutions but by buying companies that hold their debts they can easily recover what they lost and more. At any rate, actual impairments of value for CMO are highly improbable and the only issue is making sure that the share price is right.

In that vein, I had occasion to point out around the date of the “flash crash” that the real issue was not simply Capstead Mortgage’s book value, but instead the actual principal amount of mortgages held. It is natural to assume that a default-free and largely interest-rate-risk free security would trade at a premium to its principal value. However, when mortgages prepay, or suffer of defaults which are treated as prepayments, that premium disappears and the mortgage holder is left only with the return of principal. As a result, purchasing CMO at a price that is too high exposes the purchaser to risk of losses even if the business itself is not risky at all. The day after I expressed this view, the flash crash occurred and CMO was briefly pushed even below this principal value, creating a literal no-brainer buy situation. The equity interest in the principal value of the mortgages based on their last report was $10.04 a share, although the situation is complicated by preferred stock with a liquidation preference, so the ultimate worst case scenario price is actually $7.81 per share. And I don’t expect the premium to shrink to zero, even if I don’t think it should be relied on too much.

So what are my grounds for recommending selling before earnings, which are due on July 28th? Well, as I said, although interest rate spreads are the source of Capstead Mortgage’s profitability, book value is the source of its safety, and the current price of almost $12 a share represents a considerable premium over the principal value of the loans, which no doubt represents the premium over the principal value of the mortgage securities owned. In their first quarter earnings announcement, Capstead Mortgage pointed out that defaults were running high and that Fannie and Freddie were engaging in a buyout of seriously delinquent loans, which causes higher than normal amortization of premiums. Furthermore, in this uncertain environment the firm could not justify repurchasing all of the repaid principal, thus lowering the leverage and theoretically the profitability of the firm. This is no doubt a major influence in causing them to reduce their dividend last quarter from 50 cents a share to 36.

So, it occurs to me that there may be some confusion in the minds of the investing public about the distinction between book value and principal value. At prepayment rates prevailing in the 1st quarter, over 7% of the premium existing after last quarter’s earnings, or about 30 cents a share, will have evaporated due to prepayments alone, and perhaps more of that will have evaporated by the actions of the market now that Fannie and Freddie’s actions have made prepayments more likely. To those of us who track principal value this is of little consequence, since principal has just been turned into cash (and not always back into principal, as stated above), but if the market is focused solely on book value it may lead to a wave of selling as the apparent book value diminishes.

Of course, it may not be the case that the market will react so badly, as the situation with Capstead Mortgage may already be priced in, but I would just as soon not take the risk. And at any rate, holding stock of an investment company that represents too big of a premium over its principal value is a risky move whether or not it is earnings season. Therefore, I will be looking for an opportune selling time definitely before the 28th.

A couple months ago I saw a car driving along the freeway with a windmill in its roof, merrily milling the wind along as the car was zipping towards San Francisco. Of course, the car was some manner of hybrid. Although I commend the car owner for its efforts, I do not commend him for his knowledge of thermodynamics; even if the engine and the windmill both operated at the impossible level of 100% efficiency, the windmill is only recovering the energy spent to overcome the wind resistance created by the windmill itself, and when you factor in the fact that windmills weigh more than 0 pounds, it’s kind a loser all round. Of course, if the windmill could be put up and taken down so it could be used only when the car is not moving, or, better still, had an automatic elevator that would retract it into the roof of the car unless the driver was braking, in accordance with the theory of hybrids, then having a windmill in your car would make sense. I guess every good idea starts out as a bad idea that needs work.

Speaking of which, there is a bill afoot to make hybrid cars make noise, as a car running on electric motors generally makes very little. The reason for this regulation is that pedestrians who are accustomed to “stop, look, and listen” can still be run down by a silent hybrid around a blind corner. Now, the lawyer in me remembers the legal adage “For every wrong there is a remedy,” or to be more precise, “for every wrong there is a lawyer.” It follows that if pedestrians are getting injured despite complying with every rule of common sense, then the real problem is the negligence of the hybrid drivers who are going too fast to stop for a pedestrian who can see but not hear them. Imposing higher insurance requirements and/or instituting a public awareness campaign seems to me a better idea than fitting a perfectly good car with an annoying noisemaker.

So, what’s put me in a car mood lately? Fuel Systems Inc. (FSYS). Their primary line of business is devices to adjust the pressure and concentration of fuel for vehicles that run on natural gas or propane. Given the current interest in building such vehicles, spearheaded by T. Boone Pickens, takeover artist and natural gas magnate, they are in an excellent position and are considering beginning operations in the US. Many of their operations have recently been performed in Italy, where a government subsidy that has recently expired has given them considerable sales growth. Now, for alternative energy, chasing government subsidies around the world is par for the course, but natural gas vehicles do have the advantage of viability.

In terms of energy content, 5000 cubic feet of natural gas is considered equal to one barrel of oil, but because of storage and transport issues and the fact that more “stuff” can be refined out of oil, one barrel of oil has traditionally traded at about 6000 cubic feet of gas. However, a few years ago this relationship was severed by the discovery of shale cracking technology, which increases the number of places that natural gas may be extracted from. Natural gas reserves instantly became much larger, and prices fell dramatically. Of course, some say that this is an arbitrage that should eventually be corrected and either the price of natural gas will go up and oil will come down to reflect “energy content parity,” if I may coin the term, and actually the widespread introduction of natural gas vehicles might be just the catalyst to do it. Natural gas is also kinder to the environment, since pure methane contains no C-C bonds and therefore contributes less carbon dioxide per unit of energy extracted than oil does. Did I mention that Linn Energy and Breitburn produce both oil and natural gas?

Returning to the company, its numbers are fairly respectable; a P/E ratio of 10, hardly any long-term debt, and a balance sheet that is heavily weighted towards current assets. Unfortunately, the price/book ratio is somewhat high, but return on assets has been 12% recently, and return on equity around 20%, well above average for a firm that is technically a growth company. Of course, a now-expired subsidy has much to do with creating those excellent figures, but a company announcement at the end of 2009 suggested that in a post-subsidy world, the firm could look forward to $400-450 million in sales and a margin of 12-14%, which at current prices would preserve a P/E ratio of 10. As this is a firm that is investing in research and development and capital expansion, as well as some strategic acquisitions, depreciation has been running behind capital expenditures and thus free cash flow is lower than earnings.

Of course,  government subsidies, either getting them or not getting them, will have a significant impact on the future course of the company, and as a result perhaps a pure value investor may view this as far too reliant on an unpredictable future, but if the company’s projections are close to accurate the firm would still produce a respectable but not outsize return on investment without them. And I do think that natural gas vehicles will be increasing in popularity; they are a viable technology and based on a relatively cheap and abundant resource.

Tech Data (TECD) is a distributor of electronics in the US and European  areas. Its role is to sell a mix of primarily IT products from original  manufacturers and entities identified as “value-added resellers” and to  perform various related ancillary services, and it is one of the largest such distributors in the world. Approximately 30% of their sales come from HP.

It is unusual, perhaps, to find a value opportunity in the largest of anything, as value stocks tend to be overlooked, but the company’s market cap is a “mere” $1.94 billion, still below the radar of the largest institutions. More interesting for our purposes, nearly all of that value is represented by tangible assets: $900 million in cash, $2.5 billion in receivables, $1.8 billion in inventory, against $3.5 billion in liabilities, total $1.7 billion in tangible assets. This leaves a gap of about $240 million, which is just over a year’s free cash flow. The value of these tangible assets is safeguarded by agreements with some clients to return unsellable goods or to receive compensation in the event of the seller offering discounts or rebates. It seems therefore safe to conclude that much of the money invested into the firm will still be there.

In terms of investment returns, the company has a present P/E ratio of 10.12, a respectable figure for any company without a great deal of obvious growth potential. Moreover, in terms of free cash flow, the situation is  even more attractive; the firm’s depreciation has been running ahead of its  capital expenditures by more than $40 million a year for the last three years, and also the firm records $10 million in noncash interest expense for the last few years owing to its convertible debt.  However, last year’s earnings were complicated by an unusually low tax rate. At any rate, adding back in these two noncash expenses and applying a normal tax rate produces a price/ free cash flow ratio of 9.24, an attractive prospect when combined with the safety of principle above.

(I will explain the convertible debt noncash expense as an aside. Damodaran reminds us that convertible debt should be treated as straight debt plus the value of the conversion option, and the FASB seems finally to have concurred in this view.  It requires companies to estimate the current discount of a nonconvertible bond yielding what the bond actually yields to a bond that pays market interest rates, and to amortize that discount over the lifetime of the bond. The conversion price is $54 a share, more than 50% above the company’s current price, but any rate the amortizing discount is not a real cash outlay, since the company actually received par for the bonds, not the discounted value.)

As the firm is a distributor, and does not make anything themselves, it should come as no surprise that it operates in a fairly competitive sector with fairly thin margins; their gross margin is 5.2% and their net margin is 0.8%, a situation that is replicated at least in their largest competitor, Ingram Micro (IM). In such a situation, it is clear that competitiveness comes from keeping capital requirements as low as possible, and Tech Data has managed to lower their long term debt since 2007 and also has just concluded a $100 million share buyback and announced another.

As stated above, the company does much of their business in the United States and Europe. They have engaged in several strategic acquisitions in the last few years. It is no doubt a concern that they are so exposed to Europe (between 50 and 60% of their total sales) in a time where the euro is weakening, but as they are resellers, and their inventory turnover period is only 26 days, whatever they lose by selling their inventory in euros is regained the next time they buy inventory. This, coupled with  judicious use of currency derivatives, has historically kept their foreign  exchange losses to a negligible amount.

I am aware that Ingram Micro, their largest competitor, is in much the same situation; their P/E ratio is within half a percent, and most of their other relevant characteristics (net profit margins, sales/assets, etc.), deviate from Tech Data’s by what amounts to a rounding error. However, Tech Data’s sales/inventory is 12.96, while Ingram Micro’s is 11.08, reflective of higher turnover rates. As I stated, with margins as tight as in this business the ability to do more with less is highly valuable (and I will point out that Ingram’s depreciation is equal to its capital expenditures, while Tech Data’s is higher) so although the two firms are so similar I would still give the edge to Tech Data. True, Ingram Micro is more geographically diverse, having made inroads into Latin America and Asia, but I’m not sure how much of that advantage will hold up in the face of competition for those areas either from Tech Data or from third parties.

At any rate, Tech Data offers excellent safety of principal and an enviable free cash flow, and should definitely be considered for portfolio inclusion.

Orient Paper (ONP) seems to have much in common with my other Chinese ideas: A high historical growth rate; a P/E ratio of 9 at current prices, a decent balance sheet, a Byzantine corporate history involving an offshore holding company and this time not even lumbered with a set of unusually high receivables; and being still in the capital building phase; and of course their cash flows are solely in yuan. Return on assets hovers around 20%, and return on equity around 25%, but since the price/book ratio is not particularly promising, and much of their value is made up of property, plant & equipment, returns to shareholders are, as above, still hovering around 11%. Of course, a paper manufacturer needs machinery, but from a defensive standpoint, current assets are preferrable to a large proportion of property, plant & equipment because of the possibility of obsolescence.

Their current product mix is corrugating paper, midgrade offset printing paper, and digital photo printing paper, which are made using recycled paper. They claim to have a competitive advantage of being in very close proximity to their suppliers, as their factory is reasonably close to Beijing and Tianjin, both large cities that consume a lot of paper and run a recycling program.  Their inventory turnover rate in 2009 has been 21 days, which, applied to their first quarter 2010 inventory levels, suggests sales in the next four quarters of approximately $130 million, which at their current margins would produce a forward P/E ratio of 6. Of course, I view such naive projectionism with suspicion, but it is still a tantalizing data point. Digital photo paper, which they have only been producing for one quarter, seems to be a high margin business – gross profit of 66% of total sales if the first quarter’s results are typical. The company also claims to have purchased a larger assembly line to produce a higher volume of corrugating paper, which is being installed over the course of the next couple of quarters. In all, a good picture of a plucky, growing company.

Now, the perceptive reader will note that I used the word “claim” twice in the above paragraph. This is because a certain outfit by the name of Muddy Waters Research issued a report about a week and a half ago suggesting that the company is engaging in a scheme of massive fraud and misappropriation. The company issued approximately $27 million in stock earlier this year to purchase the new cardboard line, but the report claims that the entity that sold them the machines has no device that can produce at the capacity claimed by Orient Paper, and that this money has disappeared. The report also claims to have a filing with the Chinese authorities that Orient Paper’s sales are a small fraction of what they reported, and that they visited the factory in January of this year and found it in a state of dilapidation, without any trucks moving in and out the massive supplies of raw materials and finished paper that the company would have to buy and sell every day. They also claim that the company has turned over their largest customers too many times to produce the kind of sales growth they have. Muddy Waters announced that they had a short position at the time of the report’s release, which must have made them a great deal of money since prices declined from about $9 a share to about $4 and change at one point, although they have now recovered to $7.

The company is not taking this lying down, of course. One of the company’s defenders, and a long holder of the stock, claims that Muddy Waters originally visited them with a view to write a positive report in exchange for hundreds of thousands of dollars in cash and securities, a claim that Muddy Waters denies. Furthermore, the company has issued a comprehensive press release, first noting that Muddy Waters has the report of the Chinese authorities of a company with a similar name, and has produced a faint scanned copy of their own filing that shows the claimed revenue accurately. Muddy Waters has not, to my knowledge, published a copy of the document they obtained. Furthermore, the company claims that they receive deliveries of raw materials early in the morning, and their customers generally pick up their purchases either early in the morning or late in the afternoon, whereas the authors of the report visited in the middle of the day – a glib explanation if false, but perfectly reasonable if true. As for the dilapidation of the factory, one of the company’s defenders claims to have visited the same factory and found it to be untrue.

As for the large customer turnover, Orient Paper claims that their product mix shifted between the 2008 and 2009 annual reports; they used to create high quality offset printing paper that is not made with entirely recycled material, but the soaring price of wood pulp caused them to move to recycled feedstock and produce instead what they called medium quality printing paper, which of course is of interest to different customers.

As for the misappropriation of $27 million, the company claims that Muddy Waters’ contact with the equipment manufacturer must have been mistaken. Muddy Waters claims that the manufacturer’s largest line can produce only 150,000 tons of paper a year and costs $4.4 million, but Orient Paper claims this to be a ridiculous figure, and that they wish they could get hold of this mythical machine, because at their profit margins they could pay off the cost of acquiring it in less than a year. The company claims that the line they actually purchased is a custom job for $27 million and capable of producing 360,000 tons of paper a year (at their current margins it would pay for itself in a little over two years, but they claim it will produce a denser paper that should sell for higher prices (at a cost of more raw materials, obviously)), and that they provided the contract in their SEC filings previously, which provides that payment will be made at various stages of the completion of the installation.

As I hear this story I am reminded of a book called Sold Short by Manuel Asensio, who found a similar fraud, if fraud there be. A company claimed to be able to extract bitumen from Canadian oil stands without using the caustic materials that prevailed  in the established process. Having raised $70 million in capital, the company made a great show of building a factory, and hiring the fitters, plumbers, and factory technicians to fill it up, but when the hype died down they fired most of them, intending to keep on only as many people as would allow them to build a single machine that would produce one barrel of bitumen, which would justify them in their search for the next round of financing. He estimates that they spent $40 million in an effort to make it look like they spent $70, and wondered how much more work it really would have been to have actually built a factory and rolled the dice. It’s an inspiring story, and perhaps it inspired Muddy Waters to make this bold accusation in what is apparently their first public report.

So, where does that leave us who are considering an investment? Ultimately, the sad fact is that the typical investor, no matter how boundless their financial genius, is more or less powerless against fraud. Ben Graham, in Security Analysis, reminds us that bonds are largely homogenized (by credit rating, maturity, embedded options, covenants, etc.), and thus if you reject one bond in favor of a similar one, you will feel no regret. However, with stocks rejecting the right one is often as painful as buying the wrong one. And yet, if there is any indication of fraud, especially with Madoff burning freshly in the public’s mind, the defensive investor might be best served by avoiding risk on this one, at least until the smoke clears. After all, short of traveling to China to check, taking either a long or short position based on the reports of Muddy Waters, who has a big short position, or the company’s defenders at thestreet.com, who are long, seems to verge on rolling the dice. Muddy Waters certainly tells an incredible story, but I suppose most accusations of fraud sound incredible, and there are several Chinese companies (as well as several American ones), that have engaged in such fraud in the past.

However, amid this uncertainty there is a perfectly good way to play this situation, as the uncertainty is entirely binary. Either Muddy Waters is right and the company is worthless, or Muddy Waters is wrong and the company is worth at least the $9 it was trading at before they issued their report. There is nothing in between. And Orient Paper has options trading on it. A long straddle, buying both puts and calls at the nearest strike price of $7.50, was invented by options players for exactly this type of situation.

Either way, someone is getting sued over this. You don’t need an analyst to tell you that.

No doubt all of you have noticed that China has recently unpegged their currency to the US dollar, preferring to key it instead to a basket of foreign currencies. Of course, having a fully floating yuan is pegging it to a basket of foreign currencies; it’s just that the peg is to every currency in the world at whatever weight the international market allows. At any rate, this has caused the yuan to become slightly stronger, although the Chinese government is still in control of all currency exchanges and is keeping volatility clamped down, but it is a positive development for those of us who like domestically-focused Chinese stocks, as the same amount of yuan now translates to more dollars.

China has said all along that they will not be bullied by complaining foreigners, and that if they unpegged their currency it would be to serve their own interests. And this unpegging may indeed have nothing to do with Western agitation and everything to do with China’s needs. We are told that the Chinese economy is expanding and some policymakers are becoming more domestically focused, and this means that China needs concrete, steel, copper, coal, petroleum, and all manner of things, which will be consumed internally rather than be worked up and re-exported. These things are, of course, much cheaper to buy with a strong currency than a weak one. Unfortunately, since the dollar and other currencies become weaker as the yuan becomes stronger, we in the US may find them to cost more, although our own exports will become more competitive as well. In any case, those of us who own companies that have cash flows in yuan should make out very well.

Speaking of which, HQ Sustainable announced Friday that they intend to spin off their marine health and bio-products line, representing about 1/4 of the firm’s total sales but more than half of its gross profits, into a separate company, although the board claims that it will retain 65% ownership. This segment has been the recipient of the bulk of the firm’s marketing expenditures, and much of the firm’s allocations to bad debt reserves has gone to the fish farm business last quarter, although the health products division received most of the reserve increases last year. It has not escaped my notice that many domestic Chinese firms have high and increasing receivables, so it is reasonable that bad debt reserve allocations will be higher than historical levels. I’m not sure if receivables reserve against chargeoffs can be viewed as nonrecurring; on the one hand a weak global economy will mean that chargeoffs are higher than they would be on a normal footing, but with higher levels of receivables come higher levels of reserves naturally, so I’m not convinced that these chargeoffs are nonrecurring enough to be ignored.

As I stated in my last article, the market tends to punish conglomerates of unrelated businesses, on the grounds that diversification for its own sake is generally practiced on the portfolio level and it is superfluous to practice it within a company. The market reacted positively to this spinoff, and the stock went up 10% on Friday, although it gave that back up entirely on Monday. I do like spinoffs, although with the company theoretically giving up 35% of an entirely domestically-focused business the cash flows in yuan may be going to another party. Furthermore, since I view the entire company as dramatically undervalued I worry that the spinoff will result in the firm giving away the new shares too cheaply, thus paradoxically destroying value in a move intended to enhance value. However, if the sales go well, the firm will receive the premium associated with the spinoff and retain control and a large interest in an entity that has its premium unlocked, and 35% of that premium will be in cash.

On balance, then, I think that both China’s liberalization of the yuan and the HQS spinoff  are positive developments for the strategy proposed on this blog.

Investors nowadays have an unhealthy obsession with growth (and by nowadays, I mean since about 1870). I,  for my part, have no objection to growth, but as I have stated, I don’t like overpaying for growth, which usually simplifies to “I don’t like paying for growth.”

But if growth is king, and people are willing to pay daft multiples for it, and even invent a mode of  analysis called “real options” in order to justify even higher multiples (the real options concept is interesting in theory, but attempts to quantify it break down because unlike actual options, real options do not have the rigor imposed by the arbitrage elimination requirement), then a company that has anti-growth is a sort of pathetic phantom of Wall Street, doomed to wander in darkness eternally. But, as Ben Graham said of junk bonds, they exist in large quantities and someone has to own them. And sometimes, that someone should be us.

Deluxe Corporation (DLX) has been in operation for a number of years as a check printer, and checks still constitute over 60% of their income. In addition to generic checks, they also produce, either directly or through banks, checks with licensed characters or associated with causes, such as Disney, Garfield, or the National Arbor Day Foundation. They also sell checks directly to consumers as well as through financial institutions.

Since electronic payments have been increasing in popularity, and and the lowered  pace of economic activity recently has led to fewer transactions in general, their main line of business has been declining by several percentage points annually, and their total revenues have fallen from $1.59 billion in 2007 to $1.34 billion in 2009, although curiously their profit margins have gone up a bit thanks to aggressive cost cutting and control. Furthermore, the bankruptcy and consolidation of financial institutions due to the recent banking crisis have had a tendency to cost them clients, force them into a tricky  negotiating position when a bank that is one of their clients merges with a bank that isn’t, and also forced them to be more flexible in pricing when their contracts are up for renewal, since in banking nowadays every penny must count.

The firm also prints a number of customized forms for businesses, which they claim are often designed against the type of accounting and other records software commonly used by small business, as well as other printed items such as business cards and promotional materials. But with fewer businesses comes fewer forms, and of course form designing software is not so difficult to find these days, so that line is also under pressure. The firm is attempting to expand the range of business services it offers, such as web hosting, logo design, payroll management, and so on, primarily by making small opportunistic acquisitions. For financial institutions they also offer fraud protection and some record keeping and consulting services.

It is laudable that they are trying to become a one-stop shop for small business services (generally speaking, businesses have had bad results diversifying for its own sake (that can be left to stockholders themselves on a portfolio level), but if it is done pursuant to a sensible marketing plan it is at least defensible), but I do not believe at this time that the sectors they are expanding into offer them a great deal of potential for product differentiation. Their CEO was formerly the VP of “retail solutions” at NCR, which may explain the interest in product line expansion–not that I find that trying to get into the CEO’s head to be a fruitful exercise from a value added perspective.

So, that’s the bad news, and as you can see it’s pretty bad. But the next question becomes whether this bad news is priced into the company, and I’m going to say that it largely is. Even if a company is in terminal decline, it may be able to remain profitable and spit out a lot of cash along the way, as, for example,  Qwest and Windstream have despite the decline in use of of land lines in the United States. The firm has a market cap of $1.03 billion, and last year produced GAAP earnings of about $99 million.

However, this figure needs to be adjusted, both up and down, for nonrecurring events. It should be noted that cost of goods sold plus selling, general, and administrative expense, has declined from a total of $1.318 billion in 2007 to $1.117 billion in 2009, and the CEO claims he still has $65 million in costs to cut, although of course, like all costs, these are no doubt linked to revenue-generating activities and cannot be regarded as free money. But at any rate, 2009’s earnings are hampered by $32 million in restructuring charges and asset impairment charges, which are noncash and/or nonrecurring, but which are offset by a $10 million gain on early debt extinguishment, so their real earnings are a bit higher at $121 million. Their real P/E ratio is thus about 8.5. If a 10% return is standard, this suggests that the market is pricing in a terminal decline in earnings of about 1.7%, which is not quite the 4-6% decline in check volume the firm has seen historically since around the 90s but it does show us the theoretical size of the gap  that Deluxe has to fill, and the gap appears to me to be manageably small.

I believe that checks will always be in use by some people, as some people do like tangible records of transactions and not everyone likes either sending or receiving electronic routing information for single transactions, and there is substantial infrastructure built up around them as well as the tendency towards “stickiness” in payment methodologies, so it seems to me that the 4-6% decline may at some point level off. Also, it should be noted that Deluxe is hardly the only check printer exposed to this problem, so there may be opportunities for consolidation among check companies in future, and really I would like to see the CEO focus on that more than, or at least as well as, expanding their product offerings.

The wise value investor, however, does not console himself with rosy projections of the future, so these considerations may produce a bonus down the road but they should definitely not be relied on. But it appears that the firm has produced a reasonable profit margin despite a recession, and it has the free cash flow to pay down debt early. Furthermore, the first quarter of 2010 is promising, actually $5 or 6 million, or about 20% higher, than the first quarter of 2009 on my estimate of a comparable basis, and which translates to full year earnings of about $1.3 million, which produces a P/E ratio of 7.7. The firm and its analysts both expect the fall in revenues to arrest itself by 2011, but of course, they are paid to be optimistic. Depreciation and amortization of intangibles have exceeded capital expenditures, but on the other hand the company’s strategy does seem to involve future acquisitions so this should not be looked on as a source of free cash flow.

The firm’s balance sheet is not particularly robust, loaded as it is with goodwill and intangibles, but on the other hand it is not unusual for a balance sheet to look a little empty when capital expenditures are depreciated and not replaced, or for an acquisitive firm to carry a lot of goodwill. Non-replaced depreciation is the source of a lot of declining companies’ ability to spin off excess cash flow, and Deluxe has closed down 9 facilities since its cost cutting began. The firm’s interest requirements were covered five times in 2009, and fully 6.5 times in the first quarter of 2010, so it does not appear that the decline in business is likely to produce financial distress at this time, and it is the specter of financial distress that often causes the low valuations of declining companies to turn out to be perfectly accurate. The firm pays a 5.1% dividend which I believe to be more than adequately covered.

In sum, at current prices I believe that the investor in Deluxe Corporation is getting at least what he or she paid for, and the possibility of Deluxe arresting the decline at some future point would make this a reasoanbly attractive opportunity at this price and even more attractive should the price decline further.